Hong Kong banks under new stress test

Commentary: What’s really eating Hong Kong’s regulator?

HONG KONG (MarketWatch) — Hong Kong’s banking system has long been regarded as one of its biggest strengths, winning plaudits, for example, when it came through the Asian financial crisis unscathed.

More recently, the banking sector has acquired a new growth engine as China’s offshore yuan-trading center. But the breakneck pace at which Hong Kong banks are expanding both deposits and lending now appears to be causing alarm.

Granted, it is a regulator’s job to worry — but should investors also be getting more cautious?

The concern, according to the Hong Kong Monetary Authority (HKMA) chief Norman Chan, is that liquidity equivalent to 680 billion Hong Kong dollars ($87.4 billion) which has surged into Hong Kong since 2008 could reverse as U.S. interest rates rise — a case of easy come, easy go. In such a scenario, you would expect loan-to-deposit ratios to become stretched, and interbank rates to spike.

The focus on U.S. rates could well be a red herring, however, as today there seems little evidence of capital flight from Hong Kong. What we have seen is deposits being switched into yuan due to the weakness in the pegged Hong Kong dollar.

Another risk worth considering, but possibly politically sensitive to voice too loudly, is the surge in lending to mainland Chinese companies as China undergoes administrative credit tightening. The HKMA would want to be sure Hong Kong banks are not unwittingly acting as lender of last resort to Chinese companies that have seen funding dry up.

This stress test request follows an earlier warning by HKMA last month on unsustainable credit growth in Hong Kong. It highlighted the extent of lending by Hong Kong branches of mainland commercial banks to mainland companies.

Lending by Hong Kong banks surged 30% in the first three months of this year. If last year’s figures are anything to go by, much of this lending is going to mainland companies which saw loans grow 44% in 2010 to $440 billion.

We are also seeing anecdotal evidence of tighter money conditions in China, which potentially creates more hazards for lenders.

In a new strategy report, Nomura describes how the “kerb,” or shadow banking market, in China is feeling significant pain as interest rates spiral. According to the Wenzhou branch of the People’s Bank of China, the average informal lending rate grew to 24.3% in April, compared to 17.2% last August. Further, the China Daily reported that 89% of the population of Wenzhou — a city in Zhejiang province — and 57% of its enterprises borrowed outside the official banking system last year.

Another sign that lending conditions are getting tighter is rising money-market rates. Interbank rates in Shanghai broke 5% last week, according to the Chinese Securities Journal.

Granted, Beijing’s intention has been to tighten monetary policy — the use of quotas could make tightening more severe than planned. While higher financing costs can squeeze margins, if companies struggle to secure working capital, things could becomes much messier.

Something else that stands out is just how high these market rates of interest are.

It would certainly look like good business to borrow money in Hong Kong and lend in Wenzhou. If that did turn out to be the case, the HKMA would, at the very least, want to be reassured banks are maintaining commercial lending practices.

These chunky Wenzhou lending rates also made me think twice about a friend’s recent experience of being offered a 9% interest rate on his deposit. This was apparently by a party related to a major mainland bank and he was also assured the principal was guaranteed. This all seemed too good to be true, but if Wenzhou-like lending rates are becoming commonplace, a 9% deposit rate sounds less improbable.

That could provide another reason for Hong Kong deposits to leave in search of better returns. All said, the HKMA might find any number of excuses for a stress test.

While near-zero interest rates are one niggling concern for depositors in Hong Kong, the bigger risk for regulators is unsafe lending that might trigger a systematic risk to deposits. One explanation for the funds flowing into Hong Kong after the financial crises is the reputation of its well capitalized banks — something the HKMA will want to preserve.

Looking around, we are also not short of candidates that might trigger a liquidity shock, from a Greek debt default to an unwinding of the dollar carry trade, or closer to home, a potential bursting property bubble.

But there is another explanation for all the money sitting in Hong Kong dollars — it is waiting out for gains when the currency is eventually pegged to the yuan at some stage in the future.

If that did happen, the HKMA would be right to expect a big outflow of deposits as investors took profits.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.